Chapter 14
Cost of Capital
Key Concepts and Skills
 Know how to determine a firm’s cost of equity capital
 Know how to determine a firm’s cost of debt
 Know how to determine a firm’s overall cost of
capital
 Understand pitfalls of overall cost of capital and how
to manage them
Chapter Outline
 The Cost of Capital: Some Preliminaries
 The Cost of Equity
 The Costs of Debt and Preferred Stock
 The Weighted Average Cost of Capital
 Divisional and Project Costs of Capital
 Flotation Costs and the Weighted Average Cost of
Capital
Why Cost of Capital Is Important
 We know that the return earned on assets
depends on the risk of those assets
 The return to an investor is the same as the
cost to the company
 Our cost of capital provides us with an
indication of how the market views the risk
of our assets
 Knowing our cost of capital can also help
us determine our required return for
capital budgeting projects
Required Return
 The required return is the same as the appropriate
discount rate and is based on the risk of the cash
flows
 We need to know the required return for an
investment before we can compute the NPV and
make a decision about whether or not to take the
investment
 We need to earn at least the required return to
compensate our investors for the financing they
have provided
Cost of Equity
 The cost of equity is the return required by equity
investors given the risk of the cash flows from the
firm
Business risk
 Financial risk

 There are two major methods for determining the
cost of equity
Dividend growth model
 SML, or CAPM

The Dividend Growth Model Approach
 Start with the dividend growth model formula and
rearrange to solve for RE
D1
P0 
RE  g
D1
RE 
g
P0
Dividend Growth Model Example
 Suppose that your company is expected to
pay a dividend of $1.50 per share next year.
There has been a steady growth in dividends
of 5.1% per year and the market expects that
to continue. The current price is $25. What
is the cost of equity?
1.50
RE 
 .051  .111  11.1%
25
Example: Estimating the Dividend Growth Rate
 One method for estimating the growth rate is to
use the historical average
Year
 2005
 2006
 2007
 2008
 2009

Dividend
1.23
1.30
1.36
1.43
1.50
Percent Change
-
(1.30 – 1.23) / 1.23 = 5.7%
(1.36 – 1.30) / 1.30 = 4.6%
(1.43 – 1.36) / 1.36 = 5.1%
(1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
Advantages and Disadvantages of Dividend
Growth Model
 Advantage – easy to understand and use
 Disadvantages
 Only applicable to companies currently paying
dividends
 Not applicable if dividends aren’t growing at a
reasonably constant rate
 Extremely sensitive to the estimated growth rate –
an increase in g of 1% increases the cost of equity
by 1%
 Does not explicitly consider risk
The SML Approach
 Use the following information to compute our cost
of equity
Risk-free rate, Rf
 Market risk premium, E(RM) – Rf
 Systematic risk of asset, 

RE  R f   E ( E ( RM )  R f )
Example - SML
 Suppose your company has an equity beta
of .58, and the current risk-free rate is 6.1%.
If the expected market risk premium is
8.6%, what is your cost of equity capital?

RE = 6.1 + .58(8.6) = 11.1%
 Since we came up with similar numbers
using both the dividend growth model and
the SML approach, we should feel good
about our estimate
Advantages and Disadvantages of SML
 Advantages
 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can estimate
beta
 Disadvantages
 Have to estimate the expected market risk premium,
which does vary over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which is not
always reliable
Example – Cost of Equity
 Suppose our company has a beta of 1.5. The market
risk premium is expected to be 9%, and the current
risk-free rate is 6%. We have used analysts’
estimates to determine that the market believes our
dividends will grow at 6% per year and our last
dividend was $2. Our stock is currently selling for
$15.65. What is our cost of equity?
 Using
SML: RE = 6% + 1.5(9%) = 19.5%
 Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
Cost of Debt
 The cost of debt is the required return on our




company’s debt
We usually focus on the cost of long-term debt or
bonds
The required return is best estimated by computing
the yield-to-maturity on the existing debt
We may also use estimates of current rates based on
the bond rating we expect when we issue new debt
The cost of debt is NOT the coupon rate
Cost of Debt
 2 ways:
1- Trail and Error:
1
1-
Bond Value = c × [
] +
t
(1+Rd)
(1+Rd)
Rd
2- A- Discount:
Rd =
B- Premium:
d
n
Int +
(f + m) /2
Rd =
Int -
F
z
n
(f + m) /2
t
Example: Cost of Debt
 Suppose we have a bond issue currently
outstanding that has 25 years left to maturity. The
coupon rate is 9%, and coupons are paid
semiannually. The bond is currently selling for
$908.72 per $1,000 bond. What is the cost of
debt?

t = 50; c = 45; F = 1000; PV = 908.72;
Cost of Preferred Stock
 Reminders
 Preferred stock generally pays a constant dividend each
period
 Dividends are expected to be paid every period forever
 Preferred stock is a perpetuity, so we take the
perpetuity formula, rearrange and solve for RP
 RP = D / P0
Example: Cost of Preferred Stock
 Your company has preferred stock that has an
annual dividend of $3. If the current price is $25,
what is the cost of preferred stock?
 RP = 3 / 25 = 12%
The Weighted Average Cost of Capital
 We can use the individual costs of capital
that we have computed to get our “average”
cost of capital for the firm.
 This “average” is the required return on the
firm’s assets, based on the market’s
perception of the risk of those assets
 The weights are determined by how much
of each type of financing is used
Capital Structure Weights
 Notation
 E = market value of equity = # of outstanding
shares times price per share
 D = market value of debt = # of outstanding
bonds times bond price
 V = market value of the firm = D + E
 Weights
 wE = E/V = percent financed with equity
 wD = D/V = percent financed with debt
Example: Capital Structure Weights
 Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.

What are the capital structure weights?
V = 500 million + 475 million = 975 million
 wE = E/V = 500 / 975 = .5128 = 51.28%
 wD = D/V = 475 / 975 = .4872 = 48.72%

Taxes and the WACC
 We are concerned with after-tax cash flows, so we also need
to consider the effect of taxes on the various costs of capital
 Interest expense reduces our tax liability


This reduction in taxes reduces our cost of debt
After-tax cost of debt = RD(1-TC)
 Dividends are not tax deductible, so there is no tax impact
on the cost of equity
 WACC = wERE + wDRD(1-TC)
Example: Eastman Chemical
 Go to Yahoo Finance to get information on Eastman
Chemical (EMN)
 Under Profile and Key Statistics, you can find the
following information:




# of shares outstanding
Book value per share
Price per share
Beta
 Under analysts estimates, you can find analysts estimates
of earnings growth
 The Bonds section at Yahoo Finance can provide the T-bill
rate
 Use this information, along with the CAPM and DGM to
estimate the cost of equity
Example: Eastman Chemical
Table 14.1 Cost of Equity
Table 14.1 Cost of Debt
Table 14.1 WACC
Another use of the WACC
 Performance evaluation
 Economic Value Added (EVA) is the best-known
approach
 EVA = Net Operating Profit After Taxes (NOPAT)
- (Capital × Cost of Capital)
Divisional and Project Costs of Capital
 Using the WACC as our discount rate is only
appropriate for projects that have the same risk as
the firm’s current operations
 If we are looking at a project that does NOT have
the same risk as the firm, then we need to
determine the appropriate discount rate for that
project
 Divisions also often require separate
discount rates
Using WACC for All Projects - Example
 What would happen if we use the WACC for all
projects regardless of risk?
 Assume the WACC = 15%
Project
A
B
C
Required Return
20%
15%
10%
IRR
17%
18%
12%
The Pure Play Approach
 The use of a WACC that is unique to a
particular project, based on companies in
similar lines or business
 Often difficult to find pure play companies
 Ex:
Subjective Approach
 Consider the project’s risk relative to the firm overall
 If the project has more risk than the firm, use a discount
rate greater than the WACC
 If the project has less risk than the firm, use a discount rate
less than the WACC
 You may still accept projects that you shouldn’t and reject
projects you should accept, but your error rate should be
lower than not considering differential risk at all
Flotation Costs
 The required return depends on the risk, not how
the money is raised
 However, the cost of issuing new securities should
not just be ignored either
 Basic Approach
Compute the weighted average flotation cost
 Use the target weights because the firm will issue
securities in these percentages over the long term

NPV and Flotation Costs - Example
 Your company is considering a project that will cost $1 million. The
project will generate after-tax cash flows of $250,000 per year for 7
years. The WACC is 15%, and the firm’s target D/E ratio is .6 The
flotation cost for equity is 5%, and the flotation cost for debt is 3%.
What is the NPV for the project after adjusting for flotation costs?



fA = (.375)(3%) + (.625)(5%) = 4.25%
PV of future cash flows = 1,040,105
NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281
 The project would have a positive NPV of 40,105 without considering
flotation costs
 Once we consider the cost of issuing new securities, the NPV
becomes negative
Quick Quiz
 What are the two approaches for computing the cost of






equity?
How do you compute the cost of debt and the after-tax cost
of debt?
How do you compute the capital structure weights required
for the WACC?
What is the WACC?
What happens if we use the WACC for the discount rate for
all projects?
What are two methods that can be used to compute the
appropriate discount rate when WACC isn’t appropriate?
How should we factor flotation costs into our analysis?
Ethics Issues
 How could a project manager adjust the
cost of capital (i.e., appropriate discount
rate) to increase the likelihood of having
his/her project accepted?
 Is
this ethical or financially sound?
Comprehensive Problem
 A corporation has 10,000 bonds outstanding with a 6%
annual coupon rate, 8 years to maturity, a $1,000 face
value, and a $1,100 market price.
 The company’s 100,000 shares of preferred stock pay a $3
annual dividend, and sell for $30 per share.
 The company’s 500,000 shares of common stock sell for
$25 per share and have a beta of 1.5. The risk free rate is
4%, and the market return is 12%.
 Assuming a 40% tax rate, what is the company’s WACC?